What is Variable Interest Rate?
1372 reads · Last updated: December 5, 2024
A variable interest rate (sometimes called an “adjustable” or a “floating” rate) is an interest rate on a loan or security that fluctuates over time because it is based on an underlying benchmark interest rate or index that changes periodically.The obvious advantage of a variable interest rate is that if the underlying interest rate or index declines, the borrower’s interest payments also fall. Conversely, if the underlying index rises, interest payments increase. Unlike variable interest rates, fixed interest rates do not fluctuate.
Definition
A variable interest rate, sometimes referred to as an 'adjustable' or 'floating' rate, is the interest rate on a loan or security that fluctuates over time based on a benchmark interest rate or index. The key feature is that the rate adjusts with changes in market conditions.
Origin
The concept of variable interest rates originated from the need in financial markets to better reflect changes in market interest rates. It became widely used in various financial products from the mid-20th century as global financial markets became more complex and diverse.
Categories and Features
Variable interest rates are typically categorized into two types: those based on market interest rates and those based on specific indices. The former includes rates tied to the London Interbank Offered Rate (LIBOR), while the latter might be linked to the Consumer Price Index (CPI). The advantage of variable rates is that when the benchmark rate decreases, the borrower's interest payments also decrease. However, the downside is that if the benchmark rate increases, the interest payments will rise.
Case Studies
Case Study 1: In the U.S. mortgage market, many loans are structured with variable interest rates. Prior to the 2008 financial crisis, many borrowers opted for variable rate loans with low initial rates, but as rates increased, they found their payments significantly higher, leading to increased default rates. Case Study 2: In corporate financing, some companies choose variable rate loans to take advantage of declining short-term rates. For example, a tech company in 2015 opted for a LIBOR-linked variable rate loan, successfully reducing its financing costs.
Common Issues
Common questions from investors include: How can one predict interest rate changes? Is a variable rate suitable for long-term loans? Typically, predicting interest rates involves complex economic analysis, and variable rates are more suitable for short-term loans or when there is a clear downward trend in rates.
